International Business Machines (IBM) is a leading infomation technology company offering hardware, software, and services. IBM has undergone quite a transition over the last ten years, deriving 85% of revenue from software and services in 2011 compared to 65% in 2000. IBM plans to spend $20 billion between now and 2015 on acquisitions to support growth, $50 billion on share repurchases, and $20 billion on dividends.
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IBM stock has doubled over the last three years, currently trading at $202.80. Let's take a look at financial data from the last five years.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Revenue | $98,786 | $103,630 | $95,758 | $99,871 | $106,916 |
| Operating Cash Flow | $16,089 | $18,812 | $20,773 | $19,549 | $19,846 |
| Capital Expenditure | $-4,630 | $-4,171 | $-3,447 | $-4,185 | $-4,108 |
| Free Cash Flow | $11,459 | $14,641 | $17,326 | $15,364 | $15,738 |
Revenue grew by 7% in 2011 while free cash flow grew by 2.5%.
Owner Earnings
Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:
These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.
I'll calculate Owner earnings by taking the Net Income and adding back various non-cash items, such as depreciation, and then subtracting the 5-year average Capital Expeditures. I'll also add interest payments adjusted for taxes since interest is tax deductible. The results of this calculation are below.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Net income | $10,418 | $12,334 | $13,425 | $14,833 | $15,855 |
| Depreciation & amortization | $5,201 | $5,450 | $4,994 | $4,831 | $4,815 |
| Stock based compensation | $713 | $659 | $558 | $629 | $697 |
| Other non-cash items | $-93 | $-338 | $-395 | $-801 | $-343 |
| Interest Payments | $611 | $673 | $402 | $368 | $411 |
| Avg Capital Expenditure | $-4,109 | $-4,109 | $-4,109 | $-4,109 | $-4,109 |
| Owner Earnings | $12,569 | $14,492 | $14,770 | $15,659 | $17,225 |
Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine IBM's Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Owner Earnings | $12,569 | $14,492 | $14,770 | $15,659 | $17,225 |
| Invested Capital | $120,432 | $109,524 | $109,022 | $113,452 | $116,433 |
| CROIC | 10.44% | 13.23% | 13.55% | 13.8% | 14.79% |
IBM had a strong 14.79% CROIC in 2011. This means that given, say, $1 million in invested capital (retained earnings for example) that the company will generate $147,900 in cash on that investment. IBM is clearly an efficient, cash producing company. Let's see what the balance sheet looks like.
| Cash and Cash Equivalents | $11,922 |
|---|---|
| Investments | $4,895 |
| Debt | $31,320 |
| Pension Obligations | $18,374 |
| Minority Interest | $98 |
| Net Cash (Debt) | $-32,975 |
| Diluted Float | 1,204 |
| Cash/Share | $-27.37 |
IBM has almost $16 billion in cash and investments compared to nearly $50 billion in debt and debt-like obligations. With a diluted float of 1,204 million shares that leaves a net debt of $-27.37 per share. With interest payments being essentially negligible compared to owner earnings, this level of debt is not a concern.
Valuation
I use a discounted cash flow analysis to determine a fair value estimate for a company. I will use a discount rate of 15% and 12% and use the results to define a fair value range. You can read about my view on discount rates here. I will use an initial owner earnings growth rate of 9%, which is close to the 2011 owner earnings growth rate of 10% and the average analyst estimate for earnings growth of 10.83%. I will allow this growth rate to decay over twenty years to a perpetual growth rate of 3% as per the growth schedule below.
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| % | 9% | 8.7% | 8.4% | 8.1% | 7.8% | 7.5% | 7.2% | 6.9% | 6.6% | 6.3% |
| Year | 11 | 12 | 13 | 14 | 15 | 16 | 17 | 18 | 19 | 20 |
| % | 6% | 5.7% | 5.4% | 5.1% | 4.8% | 4.5% | 4.2% | 3.9% | 3.6% | 3.3% |
Using these parameters I arrive at a fair value range for IBM of $147.62-$216.00 per share.
Conclusion
With a current share price of $202.80 IBM is trading at the upper end of my fair value range, and at this time the stock seems a bit too expensive. Warren Buffett recently took a significant stake in IBM, beginning to accumulate shares in March of last year when the stock was trading around $160, much closer to the lower end of my fair value range. Having appreciated 25% since that time, the window for buying IBM at a discount appears to have closed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
